Globalization and the butterfly effect

The concept of the butterfly effect has become important in the financial world, as globalization continues to increase and capital markets are merged. Volatility in one small area of the international markets can quickly grow and develop in other markets, and “hiccups” in one corner, international markets can have global consequences. Improvements in technology and greater access to the Internet has increased the degree of influence of international markets on each other. This has led to increased cases of extreme market volatility.

The butterfly effect has become well known in pop culture, and the concept has clear applicability to Finance. She and chaos theory can provide a partial explanation for the unpredictability of the capital markets.

The origin and meaning of the butterfly effect. The expression “the butterfly effect” was first invented during the scientific conference in 1972. Scientist Edward Lorenz gave a report on their work related to weather prediction models. This expression assumes that the flapping of butterfly wings in Japan can create a small change in the atmosphere that ultimately cause a tornado in Texas. Lorenz studied at the Massachusetts Institute of technology, as small differences in initial conditions lead to big differences in the weather models. In 1961 he was introduced to the model forecast initial condition as to 0.506 instead of the exact number 0,506127 that has resulted in the completely different and unexpected weather pattern. In 1963, he wrote a study on this concept, entitled “Deterministic nonperiodic flow”. The concept of the butterfly effect shows how difficult it is to predict a dynamic system, such as weather and financial markets. The study of the butterfly effect resulted in the introduction in chaos theory.

The application of chaos theory to markets. Capital markets pass through alternating periods of calm and disturbance. However, they are not always chaotic, and the change between calm and chaos often unexpected and unpredictable. Some believe that these concepts of chaos theory can be used to understand the functioning of financial markets.

Markets tend to be growing “bubbles” that eventually burst, which leads to drastic consequences. Financial bubbles often grow due to positive feedback (reviews). When investors make money during a boom in the financial markets, other observers think that investors must have adopted a clever solution that encourages investors to invest their money in these markets. The result is a greater number of purchases and the growth rate of the stock. The chain of positive feedback displays courses beyond any logical or justifiable level. The chain, in the end, ends and the last investors remained hanging in the worst position.

The same concept can explain volatile bear markets. Markets can change unexpectedly due to external factors that is forcing investors to pay attention only to bad news. Initial sales lead to more sales, as market participants close their positions. Circuit negative feedback has a tendency to rapid acceleration, often ending in the filling of the market undervalued the stock.

Fractale and markets. Well-known scientist Benoit Mandelbrot has applied his work on fractale in nature to financial markets. He found that examples of chaos in nature, such as the shape of coastlines or clouds, often have a high degree of order. These fractal forms can also explain and chaotic systems, including financial markets. Mandelbrot noticed that asset prices can suddenly jump for no apparent reason.

Many market participants tend to ignore extreme events is less than 5% of the time. Mandelbrot argued that these “emissions” are important and play a significant role in the movements of the financial market. Traditional portfolio theory tends to underestimate how often these events happen high volatility. Despite the fact that his fractali can't predict price movements, he argues that they can create a more realistic picture of market risks.

Examples of the butterfly effect in the markets. Although technology has increased the influence of the butterfly effect to the world markets, there is a long history of financial bubbles going back to “bubble” in the Tulip market in Holland in the 17th century. Tulips served as a symbol of status among the elite of society. They traded on stock exchanges in large and small Dutch cities. People sold their property to start to speculate on tulips. However, prices began to fall, followed by panic selling.

There are more recent examples of bubbles. In October 1987, the day known as “black Monday”, the industrial Dow Jones (DJIA) lost about 22% in one trading day – the biggest drop in percentage terms ever on the market. For this fall had no obvious cause, although a week earlier there were a few days when the DJIA big fall, and was also the international problems in the Persian Gulf. Thinking about it now, we can say that partly we can blame the problems with panic selling and perhaps program trading.

The Chinese authorities have begun the devaluation of the Chinese currency. However, the main reason was probably the high level of margin (the amount, being a provision of the exchange transaction) used Chinese retail investors. When prices began to fall, investors get from their brokers, the requirement of maintaining the margin (i.e., the requirement of additional support). To meet these requirements, the investors were forced to quickly close their positions, which led to a chain of negative feedback. During the previous years, the Chinese government encouraged people to invest in the market. Markets will become more interconnected as technology improved, and the butterfly effect will continue to be a driving force in global markets.